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Paychex Inc
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Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. For the presentation, we’ll conduct a question-and-answer session. [Operator Instructions] Today’s call is being recorded. If you have any objections, you may disconnect from the conference.
Now I’ll turn the meeting over to your host Mr. Martin Mucci, President and Chief Executive Officer. You may now begin.
Thank you. Thank you for joining us for our discussion of Paychex’s Third Quarter Fiscal 2018 Earnings Release. Joining me today is Efrain Rivera, our Chief Financial Officer. This morning, before the market opened, we released our financial results for the third quarter ended February 28, 2018. Our Form 10-Q will be filed with the SEC within the next few days and you can access our earnings release and Form 10-Q on our Investor Relations webpage. This teleconference is being broadcast over the Internet and will be archived and available on the website for approximately one month.
On today’s call, I will review business highlights for the third quarter and Efrain will review our third quarter financial results and discuss our full year guidance. And then we’ll open it up to any questions. We were pleased with our results for the third quarter as we continued to deliver solid performance across our major HCM product lines. Our total revenue growth was 9% aided by our acquisition of HROI, this is the highest revenue growth in our past six fiscal quarters.
In addition, to HROI organic HR into our outsourcing services, retirement services and insurance services all performed very well in the quarter. And March 1, 2018, we announced the acquisition of lesser group and market leading provider of payroll and HCM software solutions headquartered in Denmark and serving clients in Northern Europe. We believe the combination of Lessor’s payroll and HCM software products with our full service business process outsourcing capabilities will provide a complete technology-enabled services platform in the markets that they serve and we’ll expand too.
The Lessor’s group is a good strategic fit for the following reasons. First, the vast majority of which clients across four countries don our target small business market. Lessor has a solid and scalable proprietary intellectual property with experience technology development talent. They have a season management team, they are profitable and reflect study growth with the ability to fund further growth and development. We can leverage Lessor to support our growth in Germany, where we’ve been for the past 10 years and provide an enhanced technology solution going forward there. And this acquisition offers us the opportunity to expand our market penetration in countries Lessor serves as well as other European countries in the future. We are pleased to welcome the employees of Lesser Group to the Paychex’s family and while our international operations are currently small in relation to the company as a whole, we are excited by the opportunities this acquisition provides us for further expansion and growth.
We have seen increased momentum in our sales execution as the year has progressed, in third quarter sales to new businesses were up approximately 7% compared to last year's third quarter. During our third quarter selling season in the small into the market less than ten employees, our sales teams have done very well. The mid-market up 20 plus to 500 or so, has seen an increase in the competitive intensity. However, our comprehensive HR Outsourcing services both PEO and ASO which we consider part of the mid-market performed well in both sales and client retention. HROI acquired in August has been tracking ahead of our plan. Overall despite a slow start to the year we have exited our selling season with momentum.
The labor market show signs of tightening as evidenced by our Paychex’s IHS, market small business employment watch, the growth in jobs is stabilizing because of challenges in finding qualified employees and we expect this will result in business owners making positive changes to wages and benefits as they compete for top talent.
We've seen a 12-month growth in hourly earnings of about 2.7%. The combination of this level of wage growth and consistent small business job growth are indicators of a healthy small business sector. We believe these promising indicators will continue to create opportunities for new sales in the small business market.
On December 21, 2017, the Tax Cuts and Jobs Act or tax reform was enacted and it’s the most comprehensive tax reform legislation in more than two decades. Paychex is a corporate taxpayer, it’s a significant beneficiary of tax reform. Efrain will discuss the financial impacts in more detail, however, I want to mention that as a result of the significant income tax reduction, we plan to utilize some of this opportunistic benefit to make various investments in our business. These investments include accelerating certain technology projects for the continued evolution of our customer experience, increasing our spend in marketing demand generation and sales and service strategy enhancement as well as investment in our employees. These accelerated investments will help drive future returns for our shareholders.
As it pertains to our clients, we are already helping them navigate the new tax code. Our systems were updated with the new tax rates within hours of their release and we provide many resources to our clients from online educational content to our dedicated service center with experienced payrolls specialists and onsite HR support. We are committed to delivering best in class technology solutions for our clients and business partners and our HCM solutions have continued to gain acceptance as shown by recent recognition we have received and I'd like to mention a few of those.
We were recognized as a leader in the 2018 NelsonHall Evaluation and Assessment Tool or NEAT for payroll services for the second year in a row. We received this recognition for the overall depth of the payroll delivery capability and a robust user experience which is enabled through our Paychex Flex cloud platform.
In addition to this overall distinction, we also were placed in the leader quadrant for technology and user experience, analytics and reporting and our HR cloud integration. We are proud that our Flex platform has once again been recognized as an innovative and powerful tool that enables our clients to gain productivity and focus and growing their businesses.
Business News Daily on our Paychex by saying that the Paychex PEO offering is the best in the industry for mid-sized businesses. This was based on our unmatched breadth of services along with choice, flexibility and scalability we offer clients in several areas. The hands-on support we provide our clients through our experienced HR generalists is a differentiator for us in the market. We're pleased that this media outlet recognized the culture of service that exists here at Paychex.
On March 1st we announced for the second consecutive year that the American Business Awards honored Paychex with a bronze medal for customer service department of the year as part of its Stevie Awards Program. The Stevie Awards are considered among the nation's top liners for sales and customer service. This award reflects the dedication of our service givers and the responsiveness, reliability and knowledge that help us provide world-class service to our clients.
We also were honored to earn a Silver Alexander Hamilton Award for excellence in operational risk management and insurance. We earned this recognition for our authentication and financial crime prevention initiative which works to help protect our clients from fraud activities in the digital age.
We're also proud to be named to the 2018 world's most ethical companies by Ethisphere Institute our 10th consecutive year receiving this honor. Integrity is one of our company's most important values permeating our culture. Receiving this honor underscores our commitment to leading with integrity and prioritizing ethical business practices.
Learning and development is a founding principle of Paychex and our learning and development center has again been recognized by Training Magazine as one of the top 125 training organizations for the 17th consecutive year, and we jumped six spots this year to number 14.
We're also pleased to be selected by the International Franchise Association the world's oldest and largest organization representing franchising worldwide as its preferred payroll solutions provider for its IFA membership. IFA based its decision on metrics involving service model, client retention, pricing and franchise experience.
We continuously also look to enhance the value of our portfolio and products to our clients. Recently, we announced that we will offer net spends, tip network to help clients in the restaurant industry manage what is an administrative challenge unique to their industry. In conjunction with Paycard, tip network allows restaurants to track employees' tips, calculate tip sharing and pooling amount and distributes tips electronically at the end of a shift.
I'm very proud of what our 14,000 employees have accomplished with their hard work and effort every day for our clients. I will now turn the call over to Efrain Rivera to review our financial results for the third quarter. Efrain.
Thanks Marty, good morning to all of you, I'd like to remind everyone that today's conference will contain certain forward-looking statements that refer to future events and as such involve risks. Please refer to the customary disclosures, in addition I will sometimes refer to non-GAAP measures such as adjusted operating income, adjusted net income and adjusted diluted earnings per share. These measurements include certain discrete items and one-time charges. Please refer to our press release and also refer to our investor slide presentation which breaks it all out for a discussion of these measures and a reconciliation for the third quarter and nine months of fiscal 2018 to the related GAAP measures. I'm going to cover a few things today in addition to talking about the third quarter I'll give some discussion about the fourth quarter full year and then a peek ahead into 2019.
So, I'll highlight that as we go along. Let me start by the providing the key highlights for the quarter, total revenues just over 9% to 866 million approximately 3% of the growth was attributable to HROI, as Marty mentioned they are performing ahead of where we had expected at this stage. Expenses increased 17% for the third quarter, the growth rate was significantly impacted by a few items of note, these include the following.
The acquisition of HROI that contributed 5% for expense growth for the third quarter. Very importantly, a one-time charge that we recorded following the termination of certain licensing agreements that we had. This contributed approximately 7% of total expense growth, just please note that it’s a one-time charge we decided that it’s the right time to exit those licensing agreements.
Our investment employees by a one-time bonus to non-management employees during the third quarter contributed approximately 2% total expense growth for the quarter. We didn’t call that out as a one-time charge technically it is not. But we increased spending obviously wanted to allow employees to share in the benefit of the tax reform benefit. So total expense growth was also driven by higher headcount operate and operations in sales as well as continued growth and our combined PEO business and investments in technology.
The effective tax rate was 11.7% for the third quarter compared to 34.2% for the prior year’s third quarter. So, let me explain that a bit. The significant decline in the effective tax rate is due to the tax reform, we are going to walk you through the detail for that shortly. Net income was up 29% to 260 million and adjusted net income increased 14% to 228 million. Diluted earnings per share increased 29% again for the third quarter and adjusted diluted earnings per share 15% to $0.63. Let me provide some additional color in selected areas.
Payroll service revenue increased 2% for the quarter to 455 million and the growth was driven by an increasing revenue per check which improved as a result of price increases net of discounts. HRS grew 17% to 393 million for the third quarter, it reflected strong growth in the client based across most major HCM services as Martin mentioned including comprehensive HR outsourcing services, retirement services, time and attendance and insurance services all perform well.
Within Paychex HR services, we continued to see strong demand, which along with the acquisition of HROI is reflected in strong growth in the number of client worksite employees served. Our Paychex's PEO that doesn’t include HROI has shown a surge of more than 20% of worksite employees from this time last year. Insurance services benefited from continued growth in the number of health and benefit applicants and higher average premiums within our workers comp insurance offering. Retirement services revenue benefited from an increase in asset fee revenue earned on the value of participant funds.
Interest on funds held for client grew 37% in the third quarter to $18 million, primarily as a result of higher average interest rate turned a 1% increase in average investment balances and excellent portfolio management. Now provide some color on the impacts of tax reform on our third quarter. The largest impact as a reduction in the corporate statutory rate, which took us from 35% down to 21%. Paychex as Martin mentioned, there is a significant beneficiary of this change in the tax rate.
In addition, this overall change, we had several discrete items that reduced our effective tax rate to 11.7%. The first one is that we recorded a catch-up in our effective tax rate for the first six months of the year during the third quarter. This had a benefit of 36 million or an approximate 12% reduction on effective tax rate. The adjustment was necessary to conform our tax rate to the rate we expect for the client for our full year earnings. It’s done in the third quarter, it got caught up.
We also had a one-time revaluation of our net deferred tax liabilities that was a benefit of $20 million to the quarter, reducing our effective tax rate by approximately 7%. Since we were in a net liability position on our deferred taxes, a reduction in the prospective tax rate yields a benefit because it reduces the amount of taxes we would expect to pay in the future, so we had two adjustments, there, one catch up and one the revaluation of deferred tax liabilities, again it’s all spelled out in the table should be pretty clear.
As Martin previously mentioned we intend to utilize some of this benefit, the tax reform benefit to accelerate various investments in the business. These investments are in the following areas, technology for evolution of the customer experience, and continued digital transformation within that business, increasing spent in sales and marketing to drive revenue growth, investments to drive operational excellence and efficiency, and finally investment in our employees' part of which occurred this quarter. This accelerated investment will help drive future returns for shareholders.
Let’s talk about investments and income. Our goal in our portfolio is to protect principal and to optimize liquidity on the short-term side, primary short-term investment vehicles were bank demand deposit accounts and variable rate demand notes; in our longer-term portfolio we invest primarily in high credit quality municipal bonds, corporate bonds and U.S. government agency securities. Our long-term portfolio has an average yield of 1.9% and currently has an average duration of 3.3 years.
Combined portfolios have earned an average rate of return of 1.6% for the third quarter which is up from 1.2% last year. We are realizing the benefit of a rising rate environment. Average balances for interest on funds for clients were approximately 1% for the third quarter, primarily driven by year-end bonus payments, wage inflation, partly offset by some client size mix.
Let's talk about year-to-date, just cover that briefly, total revenue up 7%, of which about 2% was attributable to HROI payroll revenue up 1%, and HRS revenue up 13% over the nine months of the prior year. Operating income growth was 3% and adjusted operating income, which excludes some one-time charge following termination of certain licensing agreements reflected growth of 7%. Net income and diluted earnings per share grew 13% and 14%, respectively, on a GAAP basis to 705 million and 1.95 a share; adjusted net income, and adjusted diluted EPS were 16% and 17% respectively.
Let me focus on our financial position next. It remains strong with cash and total corporate investments of 827 million as of February 28. 2018. Funds held for clients as of February 28th were 3.9 billion compared to 4.3 billion as of May 31, 2017. Funds held for clients as you know very widely on a day-to-day basis and averaged 4.6 billion for the quarter.
Total available for sale investments, including corporate investments and funds held for clients reflected net unrealized losses of 35 million as of February 28, 2018, compared with unrealized gains of 32 million as of May 2017. Our longer-term portfolio seen an increase in the unrealized losses due to recent increases in market rates of interest.
Total stockholders' equity was 2 billion as of February 26 2018, reflecting 539 million of dividends paid and 94 million dollars' worth of shares repurchased during the first nine months of fiscal 2018. A return on equity for the past 12 months, with a superb 45%.
Our cash flows from operations were 989 million for the first nine months significant increase of 29% over the prior year period. This change was primarily a result of higher net income and timing impacts within working capital, largely related to income taxes and RPO payroll and related, unbilled receivables for payrolls, not yet processed as of the reporting date.
So now let's turn to guidance, we're updating it as you all saw, payroll revenue now anticipated to grow approximately 2% that includes contribution from the acquisition of Lessor, which we will see in the fourth quarter. We haven't mentioned it because to this point in terms of the results because it really had no impact in Q3.
HRS revenue growth is expected to increase in the range of 13 to 14% for the full year incorporating HROI, interest on funds held for clients now expected to increase in the range of 20 to 25% that includes a very modest contribution from the Fed rate rise last week. Total revenue is expected to grow approximately 7%.
Operating income margin is anticipated to be approximately 38% that's down from our initial guidance, but the reason for that is that investment initiatives are now anticipated to impact margins for the full year by 150 to 175 basis points.
Our effective income tax rate is expected to be in the range of 28.5% 29%, investment income net is anticipated to be approximately 8 million, slightly lower than prior guidance due to the use of funds for the Lessor acquisition. Net income is expected to increase approximately 13% and adjusted net income non-GAAP is expected to increase approximately 15%.
Diluted earnings per share is anticipate to increase in the range of 13 to 14% and adjusted diluted earnings per share non-GAAP is expected to increase in the range of 15 to 16. Now let's move to things that we typically and customarily do not provide but we need to because of the number of changes that are occurring in this quarter and going forward. Let me give you a start, let me start by giving you some color on the fourth quarter.
Our current expectations for the fourth quarter are, first, payroll revenue growth of approximately 3%. That includes contribution from Lessor, which will be a little bit less than or around 1% of payroll revenue. HRS revenue growth in the range of 15 to 16%. Total revenue growth of 8 to 9%. Operating income margins of 35.5% to 36%, effective tax rate of 30 to 31%. I should say that I'll talk about the contribution of Lessor for the full year fiscal '19 when I get there.
As is our custom, we will provide guidance on fiscal 2019 on our fourth quarter call, since we are currently in the midst of our annual operating plan process, but to give you some direction based on the trends we’re experienced I will provide the following comments.
We anticipate that our payroll revenue growth for fiscal 2019 will be comparable to the rate we experience in the fourth quarter, which as I just mentioned is approximately 3% and that includes the contribution from Lessor and next year we anticipate that the contribution from Lessor will be less than 1% of total revenue.
We also anticipate that HRS will grow approximately 10% to 11%. This growth is comparable to the trend we experience this quarter, excluding the incremental impact of HROI. We have not made any assumptions of the stage on the impact of further fed rate increases, we expect they will come. But don’t know when and what the time we want be, so we will update, when we get to the fourth quarter. With the full year of tax reform in fiscal 2019, we anticipate our effective income tax rate to be approximately 24% for fiscal 2019. Since we are taking the opportunity to use some of the tax reform benefit to accelerate investments in the business we anticipate that operating margins next year will be approximately 36%.
Finally, we anticipate that the acquisition of Lessor will be modestly diluted by about $0.02 in fiscal 2019. Let me just emphasize that these comments are preliminary and anticipate that some of you would ask this and it’s important to update. So, you know the trajectory run, but there is subject to revision, when we issue guidance during the fourth quarter. Based on the trends we’re absorbing in the business and could change based on actual fourth quarter results. I want to comment also that we’re completing are now some of the impacts of the new revenue recognition standard and we’ll update you in the fourth quarter. Please refer to our 10-Q for more information. We’ll update you on all of these issues when we discuss financial guidance at the end of fourth quarter.
And now with all of that, I’ll turn it back over to Martin.
Thank you, Efrain. Operator, we’ll now open the call to questions.
Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question coming from the line of David Togut from Evercore. Your line is now open.
You called out 7% growth in new bookings for the quarter. So, two questions, number one how this compare versus your plan? And then second since you don’t regularly give out this metric, does this mean, you’ll start to slow this going forward?
Not necessarily. But I thought I was trying to give some sense of the sales momentum coming out of the quarter. What the 7% was, there was the sales, the small business sales to new business, to new businesses. So, we had a nice growth in the sales, payroll sales to new small businesses that we’re just starting up. And I think that tells a couple of things. One, that the number of new businesses continue start-up and two, that we’re getting a bigger share of those new business start-ups than we were last third quarter. That was the difference. So, we’re up 7% in sales to new businesses, on the small end over third quarter of last year.
And how does that compare versus your plans for the year?
Well we don’t talk about plan outside of the business David, but we were pleased with it, it was definitely better than we had last year, you could expect plan would have been very similar. So, it was a little stronger than we had anticipated from new business startups.
And then you mentioned growth in revenue per check, could you put some numbers around that for the February quarter?
We don’t disclose necessarily the number that we are measuring that against David but I think what we are saying is we’re getting more price out of customers, that’s the point that we are making there.
And quick final question, 20% client count growth at the PEO pre-acquisition, can you just maybe flush that out a little bit, any specific reasons why the growth is that high, you expect that to be sustainable?
Well we’re very pleased with the performance of both the sales team and for our PEO organic, as well as HRY, but this was our organic PEO. And the retention teams. So, we had a very good retention. I think the way we've been pricing and the insurance changes, the benefit plans, that we have been able to offer and the very effective way that we service clients and sold to new clients, I think there’s a growing demand for -- as we’ve talked about on other calls, the PEO service, particularly with all the changes in healthcare and tax reform and all of these things, clients especially that midmarket are looking for more of a PEO than they ever have in the past, so we picked up more clients, saved more clients and we’ve seen growth in the clients that we have in the worksite employees.
Thank you. Our next question is coming from the line of Jason Kupferberg from Bank of America Merrill Lynch. Your line is now open.
So, Efrain just a question on the fiscal ’18 core payroll, I know you’re obviously putting Lessor and therefore the Q4, so I just want to make sure we understand apples-to-apples because coming out of last quarter, I think we were talking about kind of the lower end of the 1% to 2% guidance range, so organically I guess is that still where we are or are you telling us that you feel a little bit better about where you fall in the 1% to 2% kind of organic putting Lessor on the side?
Yes, I guess what I am saying is that feel a little bit better today and in the mid-part of that range.
And so now the key selling fusion is obviously passed, so just a couple of months left in the fiscal year, any view you would share in terms of where you see net client growth landing for the year, on an organic basis and as part of that just any general observations coming out of key selling season, when you talk about the new sale to newly formed businesses but any specific color on retention for example would be great?
Yes, retention Jason we felt good about, we’re really near historic highs and at least we’re heading that way, we had a very good year end from the service and retention perspective and how we handle the clients and how we retained our clients, and even as we rolled off discounts and so forth, they have discounts that were a lot of times and that went well.
I would say on the sales side, I thought on the small end we did well as we said, we've got a bigger share of new sales to new businesses than we had last year up about 7% and in the midmarket it's just very competitive. So, I think however, when you look at it from the payroll side only it's very competitive now on both pricing and quality. On the PEO side as you have seen you know we've done very well. So, you're seeing a shift more than to that complete HR outsourcing and we're feeling good about that.
I would say overall in the sales side we feel like we have better momentum, we kind of started the first year slow, the first of the year slow, the first half and the back half we're coming out with better momentum on the sales side, kind of across the board and that includes insurance, retirement, everything is stronger in the second half, most everything is stronger in the second half.
On net client you know we only talk about it really after the year is over and so with all the things going on I'd continue to wait until we get done with the year to talk about it.
Okay and then just lastly a clarification, so the fiscal '19 guidance, the preliminary outlook there was super helpful. You talked about approximately 36% operating margins inclusive of reinvestment, can you clarify how much reinvestment is baked into that 36%.
We'll talk about in the fourth quarter Jason, because then I'm going to get into a reconciliation exercise which we are not ready to do yet, so will talk more. But you can see that I'd say two things, one is that we indicated where we'd end the year so you can see where we will be versus the run rate where or the average for 2018, and you can also get a sense Jason from where we were on our initial guidance, what kind of, what kind of investments we're making. So that's the general direction I'd give.
Thank you, our next question coming from the line of Jim Schneider from Goldman Sachs, your line is now open.
Good morning. Thanks for taking my question. Just maybe to follow-up on the prior question a little bit more, you know previously your last quarter, I think you talked about a bit of a negative mix shift in terms of client size to the smaller clients from the larger clients, or the midmarket clients, is that still, is that still in effect heading into fiscal '19 and if it is I guess that in cause implies that your client count, at least among the smaller clients could be up nicely and you're able to kind of hold the same pricing dynamics of 2% as you had. I just want to test those are indeed correct assumptions.
I would say this Jim that we're seeing compared to the quarter a year ago we're seeing some of that pressure easing, so we'll see as we -- you know the tricky part of calling the year in the third quarter is there's still a fourth quarter to go, so we'll see where we end but we think some of those pressures are starting to ease somewhat.
Got it, and then just to kind of maybe you can clarify what you just said there a little bit, does that imply that the pricing pressure you have called out in the midmarket is abating slightly or is that more of a statement about the midmarket, sorry the down market selling momentum.
No, it's really a comment about the mix shift, we were experiencing a quarter ago or the same quarter a year ago. We’re not experiencing the same level of mix shift, we were one year ago and so we would expect as we go through the year that to continue to normalize or to stabilize.
And then just a follow-up for me. If I could, with respect to the investment portfolio, I think, you had called out last quarter, you may be considering some more wholesale changes given the impact of tax reform and the rates moving parts in terms of both the types of investments you’re making, as well as the duration. Maybe just kind of comment on whether we can expect from those, some of those more wholesale changes to kind of play out and so what you are contemplating.
Yes. So, you know and everyone who has followed us know, we have tended to be pretty heavily weighted in municipal bonds with the advent of tax reform corporates look like a potential opportunity. And when we look at the after-tax returns on corporates, it looks like there may be some advantage as current rates to tilting a bit more towards corporates.
So, we’re evaluating that, we’re in the process of thinking about that. And you could see more corporate bonds in the portfolio, I recognize, it’s very easy to say well on an after-tax basis, it really won't make that much of a difference it could have a modest after-tax impact.
So, we’re looking a little that and trying to factor in what we think by the time, we get to June, or fourth quarter, when we issue the guidance. What we think the right mix for the portfolio is based on our assumption of what the fed's going to do over the next 9 to 12 months. So that’s where our thinking is right, nothing set in stone, that’s why, I didn’t call out that specific item when I talk a bit about ’19. So that’s where our thinking is currently.
Our next question coming from the line of Bryan Keane from Deutsche Bank. Your line is now open.
So, I just want to ask about the operating margin. The fiscal year ’19, Efrain you talked about 36%. Just curious, is there any one-time investments in fiscal year ’19 that won’t continue going forward? Just trying to get a sense of the real kind of continuous operating margin thereafter?
Yes. I think what Bryan, we’ll update, when we’re in fourth quarter, but some of that spending clearly is temporary over a couple year period. So, starting, we actually starting, we’ll start some of it in ’18 and it will expand into ’19. But then you’ll start to see some of that spending come down as we exit '20. So, some of the spending encourage in ’19. Some of the spending at this point, we’re thinking extends into ’20 and then we see some of this spending roll off. So, we’ll come back to you at the end of -- when we issue guidance at the end of the year.
On the effective tax rate, I know with tax reform, the corporate rate went down to 21%. The fourth quarter, effective tax rate is higher, much higher than that 30 to 31. And then for the full year in ’19 it doesn’t quite get down to '21, it gets to '24, so just curious, some puts and takes on those tax rates?
Two quick things, first thing is on ’19 is fed rate is 21, you got to bake in state taxes which are typically for us at least between three and four that’s we don’t get quite down to 21, so that’s part.
And then with respect to 2018, you only have a partial year effective of tax reform. That's why you don't quite get down to the run rate in fiscal year ’19, that’s after you kind of filtered out all of the one timers that we’ve got in there, the revaluation or devaluation, the revaluation of deferred taxes, when you kind of net it out, in very-very broad terms you’re getting about five months of benefit in 2018, in 2019, you get 12 months of benefit and remember always it’s not just 21%, it’s also state tax, and there’s other puts and takes, but that’s basically what’s going on.
I thought the effective tax rate in the fourth quarter though was higher?
The effective tax rate in the fourth quarter is but the way taxes are booked is you are booking at the annual rate for taxes in the quarter, not the tax rate for that specific quarter, so when you do the catch up in Q3, you adjust to what you think the run rate will be excluding the discrete items and then you carry it through, that same rate based on whatever your estimate is for the full year into the fourth quarter. So, you’re not doing a discrete tax rate for the fourth quarter. That's why that rate is where it’s at.
And then last one from me, I know you said 7% up in new sales in the small market, is there a metric there for new sales growth rate in that midmarket where there is a little bit more challenging with that group?
No, we really don’t break it out that much, I guess I would say, the point that I was making is on the midmarket side is payroll loan in those bundles continue to be very competitive and it’s just a more difficult, it’s about the same as it has been in a difficult competitive environment, we feel better on the PEO side which is in that midmarket and selling the complete PEO suite of services where that’s continued to be very strong, and again on the small market, that’s kind of a component of the small business sales, so what we’re saying is new bid sales to new businesses is up 7% higher than it was last third quarter.
Thank you. Our next question comes from the line of Kartik Mehta from Northcoast Research. Your line is now open.
If you look at the payroll business and the payroll service revenue growth, do you think in essence it’ll be a 1% to 2% growth over the next few years, the reason I say that we’re in a very good economic environment, seems like you guys are executing well, or do you feel as though that business -- the core business can grow much better than that?
Well I think certainly we’re looking for more than that, I think it's been a couple of -- it’s been a bit challenging on that low end from a -- sometimes from a price perspective, although when we build the bundles in we’re getting more prices, Efrain mentioned earlier, and then I think we’re hoping for a little bit stronger than that, and what’s it’s going to be in a go forward basis but that’s kind of where we’ve been for the last two years, but I do think it can be stronger than that, we just got a little bit more effective, and I think some of the investments we’re making in the marketing side in particular for demand generation, you know the world is changed and while we've been making changes on lead generation to the small side and we've made changes in the selling approach where we've sold more of those very low end over the phone and through web leads, I think we're going to be more effective, even more effective on that next year. So, I think it's got some upside to it, I think we're continuing to revolve the way we get demand generation and as well as selling.
And then Efrain as you look at the interest on funds held for clients do you think based on wage growth and some of the other things that you talked about that we should start seeing growth in that, in the float portfolio.
Yeah, I haven't gone through the numbers but we had 1% growth Kartik this quarter, so I'd anticipate that we'll have at least modest growth in the portfolio next year in the absence of some change in the direction of the mix shift that we've seen over the last couple of years.
And then just one last question Efrain, just clarification when you talked about 2019 EBIT margins at 36% I'm assuming that excludes the forward portfolio revenue and impact from that, correct.
Well, so no, I said operating margin, want to just be careful, it’s operating margins so that would include income from the float but I didn't give you any guidance as to what that float will be because at this point I don't have a good feel for where, where the fed rate rise is going to be. So that wasn't provided in that discussion.
Thank you, I appreciate it.
Thank you, our next question coming from the line of Gary Bisbee from RBC Capital Markets, your line is now open.
So, let me just [Multiple Speakers] by that last one, so the 36% is your GAAP operating margin outlook excluding any nonrecurring items that come up.
Yes, that's correct.
So that's down a couple hundred basis points, year over year and I guess part of that would be the acquisition because you said that would be dilutive as part of it, the investment, seems like you're not yet willing to talk about front and underlying trends for that, is that right?
That's correct, it's the investments plus the impact of acquisitions, that's correct Gary.
Okay, alright and so if I could just ask two bigger picture questions, can you give us a quick update on how you're thinking about the international strategy, you know you've been in Germany for a long time but it's never really grown to the point of being material now you're doing another acquisition that it sounds like bring some better technology, do you plan to really ramp investment at this in any point, should we think that it has the potential to become more material contributor to your overall growth in the next two years, or what's the strategy?
Yeah, the strategy is that I think you know, while we've been in Germany and it’s been a service model like more of a payroll specialist model type of thing, there hasn't been as much of a play on the technology side in Germany. We've grown okay there but it's not gotten, certainly as you mentioned significant from the way the company has grown from over $2 billion to over $3 billion in revenue. It's not going to get that significant, however we've been looking, we continue to look on the acquisition side for opportunities to grow in Europe, we think there was an opportunity to have a good day, particularly a low-end product that was payroll and HR and we think there was a nice opportunity there to grow because we didn't see as much competition on the a low end and they were in a place where we could acquire something so we had a couple of things we looked at and then Lessor we felt, it was very strong because it’s already a platform in four different countries including Germany and so that will give us a technology, stronger kind of sell-served technology solution on the low-end and the mid-market solution in Germany from a technology standpoint. And there are reselling and Norway, Sweden and Denmark and very strong particularly in Denmark and have a platform that can grow in to other Western European country.
So, will it get significant compare to $3.5 billion in revenue. I’m not sure, but it continues to offer opportunities for growth and profitable growth at that. And Lessor, the only thing about Lessor was, that they had a very strong development team and a very experience leadership team. So, we felt that the leadership team and development team is there in place and ready to build out that platform to grow not only in the existing four countries that they’re in, but in many more in the future.
Is there an upgrade to drop some of the technology in development that you have done with the Flex offering into that market to accelerate what they’re doing or improve their offering?
Well, I think, I mean, I think it’s certainly the expertise will be shared between the IT teams. They have a good IT leader, there was a lot, many years of experience and we worked very closely with the IT leadership team here that’s working on Flex, our mobility platform and all of our integration in the cloud for HR and payroll. So, Lessor will certainly benefit, I believe from IT team here. But they’ve got a very strong development team in the South, that was one of the thing that really was attractive to us, it’s not just a service model for everyone’s calling in and the payroll specialists is doing everything. We have that in Germany, this was adding a technology solution that has performed extremely well and is very much a leader in particularly Denmark and we think it can grow.
And then just a last one for me. Given the competitive stand to be a lot of chat or special among investors around the competitive outlook with software place. I wonder, if you could just give us a high-level update on share payroll and how that’s gone since you’ve acquired it, I know it was certainly growing robustly early on actually required it. But is that a channel to upgrade people to the more full-service model or is that an opportunity that people are agitating for a different offering from your core base and push them in that product or is it really being run separately right now and just another growth vehicle. Any color on where that?
Sure. It’s continue to perform very well from a growth perspective sales and retention. It’s very much more of a do it yourself technology play, if anything, we’ve seen the opportunities there of upgrading with you reinsure and you’re continuing to grow and you’re want a full breadth of products and services. You tend to go to Paychex and the Flex platform and we have a process in place that we’ve had for many years with they can refer clients up based and not only based on whether they see it as an individual, but the data analytics as well. They will say these clients are ready to move and will be better place on Flex and we work clients through that. But it’s been a very good low-end entry model for clients, who want to do it themselves, set themselves up and that’s one of the reasons that we kind of keep that brand separate is part of Paychex, but it had that brand that competes very effectively, I think with some of these low-end, lower price competitors who want to do it yourself products. So, they continue to perform very well and certainly at or above our expectations.
And Gary what I’d say to just to build on what Marty said. So sure informs us of what that, the part of the market that wants less expensive, do it yourself product is really looking for, but also Flex has significant self service capabilities itself, so what was your traditional full service outsourcing in the past is much more hybrid right now, and so if you want -- if you want more feature functionality you move to Flex, if you want a more basic system, you can be very well served by SurePayrolland I think that what's happening in the market, or what will continue to evolve in the market and this goes everywhere from, all the way from SurePayroll to Flex, frankly even to the PEO offering is that people are self-selecting on the kind of service they want. If they want very little DIY fast, if they want more, they’ll go to Flex, if they want comprehensive outsourcing they’ll go to the PEO, we see that continuing to evolve as we move into the future.
Thank you. Next question coming from the line of David Grossman from Stifel Financial. Your line is now open.
So, I think these questions come up in different forms, a couple of times on a call, just the dynamic with growth in the core payroll business but my recollection was that we had some midmarket retention issue in the prior year and perhaps some pricing kind of associated with that, and that perhaps we’re anniversaring those losses now, or just helping put some upward lift into the payroll growth rate going forward, so I mean first am I getting that right, am I remembering that’s right, and if so, how do we think about kind of what your expectations are for that kind of unit pricing dynamic going forward and core payroll is 1% to 2% really at this stage the maturity what we should be thinking for the business or should we be thinking differently now that you’ve got an opportunity to invest in a different way?
So, David great compound question there, so let me parse it into three pieces, so the first part of your question, yes that's correct we’re anniversaring some of the effects that you did mention. I'd say it's less about losses and more about what the mix of sales was less a year ago, less midmarket, more small market, so I think we’re anniversaring, starting to anniversary, some of that and also client retention plays into that picture. That’s part A.
Part B, the pricing dynamic so we've always said it’s one to three, you can’t continue to price at that level, especially if you deliver value for the products that you provide the clients. If you provide excellent service, clients are very willing to give you -- consider those kind of price increases. I think what's changed is that going in price, when you sell now is more competitive, and that’s a little bit more challenging but you still have an opportunity to price in the range that we have been trying you can’t. And I didn’t get the last part of the question.
Well the last part of the question really was how to think about that pricing unit accretion going forward, and perhaps what's assumed in your preliminary fiscal guide, because it sounds like last year -- in the last 12 months at least we’ve got probably 1%-unit growth and the balance of the growth came from pricing, how should we think about unit growth going forward? As that has probably been a challenge for the company and I was curious whether or not now that you’ve got the tax rate benefits, reinvest at a higher rate, you know should we be hopeful at least that we can get some acceleration in that unit growth.
I think that's a fair comment. Some of those investments are going to be geared to precisely that and I think you're right that that's where we're going to be putting some of our effort.
I think a couple of things, one is that I think very right as I mentioned earlier, some of the investments are pushing more toward accelerated marketing and demand generation. I think we were slower to this than we should have been as far as picking up more leads on the web, and then being able to close them more effectively, I think we've made some big changes this year into that, it's starting to pay off and we'll continue to accelerate that, there's just a different, a changing, I don't want say traffic like it's everything, but there's a changing model here, where as you would expect more people are searching, researching and deciding online and then making the call very quickly so it's going to have this balance, that we've been investing more in the virtual sales team, we got to have this balance of virtual sales, telephonic sales, who handle those leads and close the sales and the field and focusing the field on the larger clients even than some of the ones that come in on leads.
Because on the leads they're ready to buy and do it over the phone or over a WebEx type of thing, they just want to see it, research it, and buy it. So, we're seeing that change and then on the midmarket, we definitely did see better retention this year than we did last year on the midmarket sales and through the end of the year, so that was a real positive for us and I think that's just you know more comprehensive products, better service and so forth.
Thanks for the clarification on that, and just two quick follow ups, on was just the WSC growth. I just want to make sure that I heard that right, did you say 20% growth in WSCs on an organic basis, or was that client growth?
That was WSC growth not client, so that's correct. That's what we had for the PEO by the way that's what we're talking about.
And that just seems like an extraordinarily high number to me based on history, I thought we were tracking kind of is that 10 to 12% range. So, am I remembering it right, because that seems like a big number to me, and if it is what changed?
I think as usual David your memory is good, and you are getting it right, it was 20% we had a really…
We had strong earnings and retention.
We did actually very well. Good quarter.
Was it a competitive dynamic, was it a market dynamic, I mean that just seems like close to 2X year growth rate where it had been trending and just curious was there some change in the business that would drive that kind of exceptional acceleration?
You know I'd say a couple of things, so we have made a big investment in sales execution on the PEO side, and it's, those things don't occur overnight and we're getting benefit from that, and I would say that's really kind of probably the number one reason why we're seeing that kind of benefit.
I think also -- on the sales side as Efrain mentioned also retention, as I said we've been able to perform very well and therefore we've been able to have very good plans, insurance plans and pricing on those plans and I think that we definitely saw a nice improvement in retention as well. So, on both sides of the organic PEO, this is without HROI, we performed very well and we've been very focused on it as well.
I just want to, David, one other caveat to that is, we're just talking about PEOs not necessarily. So, at year-end, we update our entire worksite employee number, which includes our lower end product the ASO and the PEO. We still have more clients on the ASO, more worksite employees on the ASO. But we put a lot of focus on PEO, because we think there is opportunity there and its starting to pay benefits.
Right. So, there is no increase in the risk profile business in terms of at risk or health insurance or anything like that?
Sure. Absolutely, there is no increase with profile and the risk profile. And of course, we monitor that very carefully.
Our next question coming from the line of James Berkley from Barclays. Your line is now open.
Just two questions here real quick. First, I noticed on the page 5 of the press release, you guys took out the $0.10 impact from the changing annual effective tax rate of 36 million there. But it looks like year-to-date, it was not taken out, it was left along so you got the 194 versus 184 if you just add up each quarter individually. Is that fair and then does that imply about $0.60 for 4Q for the full year guidance. How should we think about that?
We have to look at that Jim, I don’t think that -- I think it will, it should be spelled out pretty clear in our investor presentation.
And then quick follow-up just on the Lessor Group. Just commenting on some of the target markets, you’re seeing beyond the one that you’re currently exposed to there in Europe and if you could give any detail around the margin or the growth rate of the company? That will be great too. Thanks.
Can you say that again, I couldn’t catch that last part? Was that European on Lessor or…
Yes. So, you’re talking about some of the markets that you are currently in the ability to kind of realized revenue synergies hopefully in Germany overtime. But what are some of the other markets that, I think you could expand until beyond that ones that it’s exposed to now?
Sure. I think there is always some work being done our product that would get into Spain or France and Poland. So, I think the other markets, something that we haven't been able to do, because we didn’t want to necessarily put the investment into the development of each platform. We’re kind of at a stage now and Lessor is at a stage that we found, that has a solid platform and a way to update and build out those platforms for various countries at an effective way. They are profitable and we believe that durable service model, which is very much a do it yourself model is going to be a good way to go in Europe right now as we move forward. There is a number of and with the success they have seen in those four countries. We think we can easily expand others. Our focus right now will be, how we drive penetration in those four countries, but then after that expand to others probably more 18 to 24 months down the road.
Great. Thanks a lot.
Jim one, I think, I understood your question, I apologize, I was not tracking. So, when you look at the table, the $0.10 really relates to Q3 and it’s the catch-up that now gets Q3 to close to $0.30, I’m sorry 30%, when you make the adjustment in that quarter. You’re catching up those first two quarters, that’s why Q3 is low and then you exit the year at around that rate. There is puts and takes there. So, if that’s not clear, just give me a buzz back and we can talk about it further.
Our next question coming from the line of Jeff Silber from BMO. Your line is now open.
Hey good morning guys, it’s Henry Chien calling in for Jeff. Just a high-level question. I know you mentioned some of the metrics kind of highlighting the tightness of the labor market and wage inflation, or earnings picking up, just curious in light of that kind of environment with the tighter labor market what’s kind of changed for your sales or demand from your perspective?
Well I think we’re not having a strong -- the recovery was very long and slow from additional jobs and new business startups, new business startups have now kind of gotten back to where they were kind of pre-recession long time ago now, and seemed to be holding and then in the jobs, the job growth is back to kind of a normalized component, at least in our review for -- and this is clients under -- this is businesses under 50 employees is what we focused that on. We’re back to kind of a normalized growth of businesses and employment growth, back to kind of 2004, which was our base year.
And then the wages should pick up some, so we've seen wage growth that held under 2% for -- pretty consistently until about a year ago. Now it’s starting to tick up, we actually saw it very close to 3% which was nice and strong, and now it’s kind of drifted back into that 2.7% which is a little strange, but I think it's going to end up closer to that 3% because of the shortage of employees, with specific skills and so forth.
Plus, you are also seeing at the very low end a lot of minimum wage increases are going into effect. So when you put that in depending on the time of the year you are going to see something probably closer to 3% and in those kind of front end jobs you are going to see something stronger even probably 4% to 5%, and I think, all of that kind of bodes well for checks, also, what really bodes well is that with that job growth and wage growth, more and more businesses small and midsized are going to need products that are full payroll and HR outsourcing.
And that kind of leads to my follow-up question for the investments that you’re making just curious what’s sort of driving the decision to ramp up investments and any color you can give on what these investments are, or is it focused on sales and execution in light of the more positive environment or any kind of color you can give that’d be great?
I think you always want to spend more to accelerate growth and so we wanted to take advantage of some of the tax reform benefit to do that, so what we’re finding is technology spends so we, particularly in the client interface, so from mobility platforms and what we’re building into our mobility platform it's been very popular with clients. The reporting platform, the analytics, all of the things that clients want and the HR administration piece of it, there's always things that we want to do faster than we already have to be ahead of competition and we decided that given this benefit to us because we are very profitable company this is a good time to reinvest and accelerate a few of these projects that are on our roadmap and so you'll see in enhancements to a client interface and both mobility and in the breadth of products as well, we’re accelerating those.
If you look at marketing spend the marketing spend will go up as well as the sale spend, because we think with marketing -- new marketing generation tools and a bigger spend and a more focused spend, that we can get more leads into Paychex and that we’ll be able to close more sales with the focus of those leads. So we’re putting more emphasis on our marketing leads, our marketing spend and demand generation, as well as you’ll see the sales team grow, we’re not kind of right at this point ready to say how much it'll grow, but there will be a combination of growth between the virtual or telephonic sales teams and the field sales teams, because we think the opportunity is there to sell more if we had more people out there, which is a good thing.
Got it, okay great, thanks so much for the color.
Thank you, our last question coming from the line of Mark Marcon from Baird, your line is now open.
Good morning, thanks for squeezing me in. Had a few questions, kind of clean ups but on the investments in as they relate to the operating margin going to 36% for 2019. Where would they fall in terms of between direct operating expenses versus SG&A, how should we think about that, number one. And number two as it relates to that specific item, you know it sounds like some of that's going to continue through 2020. But once we normalized how should we think about the pattern of margin expansion and pace of margin expansion going forward once we once we get through that investment phase that's number one.
Number two and I'll be glad to repeat these number two, on the PEO side where you're getting the wins, are those primarily coming from clients that have existing PEO relationships or are you seeing a lot of white space out there where you're selling into clients that don't have a current PEO and how does that make you think about the PEO market and number three you didn't buyback any stock this quarter, wondering is that because of Lessor. How should we think about that?
Let me start with the PEO one. Efrain can jump in on the stock one and the others. I think one on the PEO I think it's a combination Mark. I think we certainly have been able to win over with our service and our plans and our pricing in sales execution existing PEO clients in a number of markets. So, I think we've had very competitive offerings that have done well. I also think we're selling PEO, we also have seen experience with selling PEO to some new client that have not had PEO before and as I mentioned earlier I think it's continuing to evolve that more and more clients are looking for that HR support and the co-employment is getting more known not only because of us but because of competitors out there as well. That is becoming more known and more comfortable with clients who have not experienced that before, because of tax reform, because of you know all of the HR requirements, because of healthcare.
You know, things are changing it's probably the most confusing one of the most confusing times we've ever had from what federal government is doing in and of, the federal government, the state governments I've mentioned before, regulations are going up, minimum wage changes, family leave act changes, there's never been a time frankly when there's been probably more confusion as to what I have to do particularly if I'm a multistate business. So, I think PEO is both, PEO for us has definitely been both those who already have it and those who don't have it but are now finding it as a good alternative.
Marty, is it silly to think, take all your comments together, sounds like a pretty obvious opportunity, no?
Definitely, definitely and that's why as Efrain mentioned, I think I've mentioned, we put more sales teams towards this, this was behind acquisition of HROI, we felt it was a very good PEO that was doing some things different than we were and they were very effective, they were ahead of what we expected from them. So, and it's early, just from last August so I think this is definitely an opportunity and you're seeing us put more investment in the PEO and it from a sales and execution standpoint and product standpoint.
The more you put in, the more encouraged you’re getting?
Yes. I would definitely say that right now.
Mark as to your question on the split between the investment. So, let me just bracket them. I can’t give you direct answer yet, I’ve got a wait till fourth quarter. But in part is, because there some of the categories might shift between our current…
Sure. And part of it is just an allocation that’s subjective.
Right. But so, let me just sort of generally say that that a reasonable way to think about it is, that about a third of the investments would be, on the operating expense side and two-thirds would be on SG&A. before I go further, just remember that in our business, ITs and G&A. So that’s why two-thirds is going into SG&A, Marty mentioned sales and marketing demand driven spending that will be one focus and then lots of IT projects that were on board and that we’re accelerating forward to try to get in over the next couple of years or so accelerate the opportunities we get from doing that. So more to come in Q4 and we can talk about it then. On the share buyback, we buyback for dilution if you look back at where we were in the quarter, we’re not too far from or expected to be, we’ll do more buying as we head into first quarter next year.
And then just going back on the just the pace of margin expansion once we get past the early part of fiscal ’20?
Yes. So, I think when we get beyond that, I’ll have to, we’ll reserve discussion on how quickly we can expand margins. But we certainly be our expectation getting through this period that we continue to expand margin and part of the investment is intended to drive that as we come out of the period. How quickly, we’ll have to see, how the projects go and how they payoff. But that’s clearly in the forefront of our mind.
Yes. The idea of these investments and taking some of the benefit from tax reform spend is the drive more better and stronger top-line, sustainable top-line growth. And that we’ll start to bring the margin back is opposed to just trying to look at more we’re cutting costs. We’ve always been good at keeping costs out, we’re pretty targeted as to where these investments are going to be and hopefully how long they’re going to last and then start to see margin improvement, because of the growth in the top-line back into the ranges that we have in the past.
And then just thinking about the balance sheet and the strength of the free cash flow and the sustainability of it. You mentioned, you might change a little bit, what you’re doing in terms of the investments on the slowdown. How are you thinking about just the balance sheet in general, I mean just given the recurring nature of the cash flows and the strength of the business, leverage levels, things of that nature?
Yes, Mark. What I’d say is as we look to tax reform another bucket that we targeted was at the margin being able to do more M&A. I think the fact that we did Lessor in Q3 is the first indicator of that. We will be active in looking at opportunities at this stage, non-transformational but we think we have obviously a lot of ability to do the right kinds of M&A and we think there’s targets out there that are of interest to us.
Thank you. At this time there’re no questions over the phone. Speakers you may proceed.
Thank you. At this point we’ll close the call and if you’re interested in replaying the webcast of this conference call, it will be archived for about 30 days. Thank you for taking the time to participate in our third quarter press release conference call and for your interest in Paychex. Have a great day.
Thank you. That concludes today's conference. Thank you all for joining. You may now disconnect.